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ACCA | F5 - Kaplan Exam Tips December 2010

Learning Curves Performance Evaluation of a Public Organisation Activity Based Costing Mix and Yield Variances Target Costing Throughput ROI / RI ACCA | BPP - F5 Performance Management Exam Tips December 2010 To discuss techniques such as ABC compared to traditional costing techniques such as Absorption Costing. Pricing combined with other parts of the syllabus. Budgeting: The appropriateness of budgeting types or the behavioural impacts of types of budgeting. Numerical elements in a budgeting question could include flexed budgets or time series analysis. Standard costing & variance analysis: Be prepared to discuss performance, and whether variances are an indicative measure of good / bad performance. Performance Measurement and Control: Questions could focus on the public sector, divisional performance measures such as ROI / RI or a discussion of the impact on performance of various transfer prices. Question 1 ABKABER PLC (a) (I) absorption based on Labour hours OAR Total overhead cost = $12,000,000 Total labour hours = 500,000 hours Overhead per labour hour = $12,000,000/500,000 hrs = $24/hr Sunshine $ Direct labour ($5 p.h.) Materials (at $400/600/900) Overheads (at $24) Total Costs Output (Units) Cost per unit Selling price Profit/ (loss) per unit Total Profit/ (loss) Total Profit 1,000,000 800,000 4,800,000 6,600,000 2,000 $3,300 $4,000 $700 $1,400,000 $4,180,000 Roadster $ 1,100,000 960,000 5,280,000 7,340,000 1,600 $4,5875 $6,000 $1,4125 $2,260,000 Fireball $ 400,000 360,000 1,920,000 2,680,000 400 $6,700 $8,000 $1,300 $520,000

(ii) Activity Based Costing Deliveries to retailers $2,400,000/250 = $9,600 Set-ups $6,000,000/100 = $60,000 Deliveries inwards $3,600,000/800 = $4,500

Sunshine $ Direct labour ($5 p.h.) Materials (at $400/600/900) Overheads: 1. Deliveries at $9,600 2. Set-ups at $60,000 3. Purchase orders at $4,500 960,000 2,100,000 1,800,000 6,660,000 Output (Units) Cost per unit Selling price Profit/ (loss) per unit 2000 $3,330 $4,000 $670 $1,340,000 Total Profit $4,180,000 1,000,000 800,000

Roadster $ 1,100,000 960,000

Fireball $ 400,000 360,000

768,000 2,400,000 1,350,000 6,578,000 1600 $4,11125 $6,000 $1,88875 $3,022,000

672,000 1,500,000 450,000 3,382,000 400 $8,455 $8,000 ($455) ($182,000)

(b) REPORT ABKABER PLC To : Directors of Abkaber plc From : Management Accountant Subject : The Introduction of Activity Based Costing Date : December 2002 (i) Direct costs They are unaffected as they are directly attributable to units of output. The labour hours allocation basis Under both methods it will gives the same result. There appears to be no relationship between overheads and labour hours. ABC and labour hours cost allocation ABC attempts to allocate overheads using a number of cost drivers rather than just one as with labour hours. It thus attempts to identify a series of relationships. Moreover, those in favour of ABC argue that it is activities that generate costs, not labour hours. While costs are likely to be caused by multiple factors, the accuracy of any ABC system will depend on both the number of factors selected and the appropriateness of each of these activities as a driver for costs. Each cost driver should be appropriate to the pool of overheads to which it relates. As noted already there should ideally be a direct cause and effect relationship between the cost driver and the relevant overhead cost pool, but this should also be a linear relationship (ii) The Finance Director Using the labour hours method of allocation the Fireball makes an overall profit of $520,000 but using ABC it makes a loss of $182,000. There is thus a significant difference in the levels of cost allocated and in profitability between the two methods, to the extent it affects the conclusions on the Fireballs viability. The major reason for the difference appears to be that while labour hours are not all that significant for Fireball production, only 80,000 hrs, the low volumes of Fireball sales cause a relatively high amount of set-ups, deliveries and purchase processes, and this is recognised by ABC. If the Fireball model is to continue, a review of the assembly and distribution systems may be needed in order to reduce costs.

There may, however, be other non-financial reasons to maintain the Fireball, e.g. maintaining a wide product range and raising the reputation of the motorcycles, which may increase sales of other models. The Marketing Director The marketing director suggests that ABC may have a number of problems and its conclusions should not be believed unquestioningly. These problems include: 1. For decisions such as the closure of Fireball production or the pricing of the new motorbike rental contract, what is really needed is the incremental cost to determine a break-even position. While ABC may be closer to this concept than a labour hours allocation basis, its accuracy depends upon identifying appropriate cost drivers. In these circumstances the introduction of ABC in normal costing procedures may have restricted benefits. 4. There may be interdependencies between both costs and revenues that ABC is unlikely to capture. Where costs are truly common to more than one product then this may be difficult to capture by any given single activity. 5. As with labour hours allocations it is the future that matters. Any relationship between costs and activities based upon historic experience and observation may be unreliable as a guide to the future. The Managing Director ABC normally assumes that the cost per activity is constant as the number of times the activity is repeated increases. In practice there may be a learning curve, such that costs per activity are non- linear. As a result, the marginal cost of increasing the number of activities is not the same as the average. Also, in this case, fixed costs are included which would also mean that the marginal cost does not equal the average cost. The MD is correct in stating that some costs do not vary with either labour hours or any cost driver, and thus do not fall easily under ABC as a method of cost attribution as there is no cause and effect relationship. Depreciation on the factory building might be one example. The Chairman From a narrow perspective of reporting profit it is true that the two methods give the same overall profit as is illustrated in requirement (a) at $4,180,000. There are, however, a number of qualifications to this statement: If the company carried inventory then the method of cost allocation would, in the short term at least, affect inventory values and thus would influence profit. If the ABC information can be relied upon, notwithstanding the above qualifications, then a decision could be taken to cease Fireball production as it generates a negative contribution of $182,000. This was not apparent from the use of labour hours; thus by the introduction of ABC and the subsequent closure decision profits would, all other things being equal, improve by $182,000. Question 2 SPRING PLC Key Features of ABC ABC says that activities create costs, while products consume activities. ABC attaches overheads to product cost in a more meaningful way than traditional absorption costing. Overhead costs are collected in cost pools. Activity-based costing uses more cost pools than traditional absorption costing. In ABC, the link between cost pools and product cost is called a cost driver. A cost driver represents the extent to which a particular activity has been used by a particular product in its production. Activity-based costing is uses more cost drivers than traditional absorption costing The key steps in introducing an activity-based costing system Identify the main activities that generate costs Assign costs to cost pools Select appropriate cost drivers for assigning cost pool costs to products Calculate activity-based charge rates to assign the cost of activities to products Question What are the key steps in introducing an activity-based costing system benefits Product costs are more accurate. Overhead costs are assigned on a cause-and-effect basis rather than on an ad hoc or subjective basis. Cost behaviour is better understood due to the analysis of activities. Cost control is facilitated through the identification and management of cost-generating activities. For example, in order to reduce set-up costs, production planning could be used to eliminate short production runs and hence reduce the number of set-ups. Poor decisions due to inadequate cost information are less likely to occur. Question What are the benefits of ABC Disadvantages It is expensive to Identify the main activities that generate costs. Cost of training staff to use the new costing system. Based on cost and benefits maintaining an ABC system may exceed the benefits gained. It may be most appropriate where indirect costs are a significant proportion of total cost, or where a wide product range is maintained. Not appropriate where a company produces a single product

Spring plc should consider the significance of indirect costs to its product costs and undertake a cost-benefit analysis before making a decision to implement an activity-based costing system. Spring plc should also consider that further developments can flow from the introduction of an ABC system, for example in budgeting Question What are the disadvantages of ABC b. The need for the measurement of organizational and managerial performance Both are very linked, since managers are the key decision makers in an organization and their decisions therefore determine organizational performance. They need to be measured as part of the control process within an organization. In order to compare actual performance with planned performance and take actions to correct or modify continuing performance in order to achieve planned performance. They can be measured in a wide variety of ways, depending on which aspect of performance, financial or nonfinancial, is the object of interest. A wide variety of measures can be used to assess both performance. Financial performance is of interest to internal and external stakeholders who are concerned to monitor the progress and risk of their investment. Examples of financial performance measures include: Profit Managers are expected to deliver increasing profits and organizations are expected to produce profit increases equal to or greater than their competitors. Earnings per share EPS is a profit measure of interest to shareholders and the financial market, since it represents the maximum dividend per share that a company could pay. Managerial rewards could be linked in part to meeting performance targets based on earnings per share. Cash flow Profit does not measure directly the ability to generate returns for investors, many shareholders and providers of debt finance prefer to concentrate on changes in cash flow as a means of assessing managerial and organisational performance. Costs A focus on managerial and organisational performance in terms of cost control or cost reduction may be especially appropriate for organisations Share price One of the ways in which shareholders receive a return from their investment in a company is through capital growth, they will be interested in assessing managerial and organisational performance in terms of share price growth. Non financial measures 1. Non- financial performance measures may be quantitative or qualitative. An example of a quantitative performance measure is the number of complaints received from customers. An example of a qualitative performance measure is that most customers are very happy with the after-sales service provided by the organization. 2. Modern organizations compete in terms of product quality, flexibility and reliability, customer satisfaction, and product dimensions such as after-sales care and customer loyalty. 3. These features are captured by non-financial indicators such as number of customer complaints, number of warranty claims, and quality ratings (such as the star ratings of hotels or restaurants, or the position of an organization in a league table). 4. A more balanced assessment of organizational and managerial performance will consider both financial and nonfinancial performance. 5. For example, Kaplan and Nortons Balanced Scorecard considers the customer perspective, the innovation perspective, the internal process perspective and the financial perspective, and requires the identification of quantitative and non-quantitative goals and performance measures. Question 3 SPECIFIC RELEVANCE (i) In target costing a market is identified for a product. The required return by the company from the venture is quantified. Expected sales revenue required return = target cost. It is at this point that standard costs may be usefully employed as part of the procedure. A standard or estimated cost may be prepared using the current expected specification for the product and incorporating current production methods which are envisaged: This standard cost may exceed the target cost and the cost gap of current standard cost minus target cost must be investigated. Efforts may then be made through value engineering and the use of cost engineering tools such as JIT and TQM to close the gap between the current standard and target costs.

The current standard cost provides a start point from which progress can be made. (ii) The use of backflush accounting will be seen as relevant where the overall process cycle time is short and levels of material and WIP are low. Such conditions are likely to occur where a just-in-time approach to production and sales is in force. The backflush accounting system simplifies the accounting records by avoiding the need to trace the movement of materials and work-in-progress through the production processes. The backflush accounting system is likely to involve maintaining a raw materials and WIP account and possibly a finished goods account. The use of standard costs and variances is likely to be incorporated into the accounting entries. Transfers from raw materials and WIP account to finished goods (or cost of sales) will probably be made at standard cost. Any inventory of raw material and WIP which still exists will probably be valued at standard cost. The difference between the actual inputs to and the standard charges from the raw material and WIP account will be recorded as a residual variance. This will be written off to profit and loss account. The investigation of losses and inefficiencies relating to material, labour and overheads is more likely to be implemented using non-financial indicators rather than detailed cost variances. (iii) Transfer pricing is used for the valuation of goods moving from one division to another in a group of companies. Transfer prices may be cost based, possibly with the addition of a profit mark-up to arrive at a notional selling price. The use of standard costs as the basis of arriving at the transfer price may be examined in the context of each of the issues stated above. Management at the supplying division may see the requirement to transfer at standard cost rather than actual cost as an infringement of their autonomy. The use of a planning and operational approach to standards and variances may help overcome this. The use of revised standards which incorporate any non-controllable planning variances may be seen as an acceptable compromise. Where a notional profit mark- up is added, the receiving division is more likely to accept a transfer price based on revised standard costs. In this way the profit mark-up will not be inflated due to inefficiency at the supplying division. Performance measurement in terms of reported profit at the receiving and supplying divisions is more likely to be accepted where standard costs are used as the basis of any transfers. To some extent the use of transfer prices based on standard costs will help in decision-making by receiving divisions which is in the best interests of the group. Where transfer prices are based on (inefficient) actual costs the receiving division may decide to purchase externally at what seems to be a lower price. The use of standards in this decision process would, of course, assume that the adverse variances (actual standard) which exist will be investigated and eliminated. Question 4 CSIX LTD (a) Backflush accounting focuses upon output of an organisation and then works backwards when allocating costs between cost of goods sold and inventories. It can be argued that backflush accounting simplifies costing since it ignores both labour variances and work-inprogress. Whilst in a perfect just-in-time environment there would be no work-in-progress at all, there will in practice be a small amount of work-in-progress in the system at any point in time. This amount, however, is likely to be negligible in quantity and therefore not significant in terms of value. Thus, a backflush accounting system simplifies the accounting records by avoiding the need to follow the movement of materials and work-in-progress through the manufacturing process within the organisation. The backflush accounting system is likely to involve the maintenance of a raw materials and work-inprogress account together with a finished goods account. The use of standard costs and variances is likely to be incorporated into the accounting entries. Transfers from raw materials and work-in-progress account to finished goods (or cost of sales) will probably be made at standard cost. The difference between the actual inputs and the standard charges from the raw materials and work-in-progress account will be recorded as a residual variance, which will be recorded in the profit and loss account. Backflush accounting is ideally suited to a just-in-time philosophy and is employed where the overall cycle time is relatively short and inventory levels are low. Management will still be eager to ascertain the cause of any variances that arise from the inefficient usage of materials, labour and overhead. Question 5 PARSER LTD (a) Opportunity costs represent the value of the loss or sacrifice when choosing between scarce alternatives. Lack of scarcity implies zero opportunity cost.

Costs for special order: Costs for special order: Notes Direct wages 1 Supervisor costs 2 General overheads 3 Machine depreciation4 Machine overheads 5 Materials 6 Costs for special order: Costs for special order: Notes Direct wages 1 Supervisor costs 2 General overheads 3 Machine depreciation4 Additional maintenance Machine overheads 5 Materials 6 Interest cost

$ 28,500 11,500 4,000 2,300 18,000 34,000 98,300 $ 31300 1000 1000 0 500 22000 31500 900

Notes: (1) The choice lies between the two subcontractor costs that have to be employed because of the shortage of existing labour. The minimum cost is to have subcontractors employed who are skilled in the special process. (2) Only the difference between the bonus and the incentive payment represents an additional cost that arises due to the special order. Fixed salary costs do not change. (3) Only incremental costs are relevant. (4) Depreciation is a period cost and is not related to the special order. Additional maintenance costs are relevant. (5) The relevant costs are the variable overheads ($3 6000 hours) that will be incurred, plus the displacement costs of $2 2000 hours making a total of $22,000. (6) Since the materials are no longer used the replacement cost is irrelevant. The historic cost of $34,000 is a sunk cost. The relevant cost is the lost sale value of the inventory used in the special order which is: 7,500 kg $420 per kg = $31,500. (7) Full opportunity costing will also allow for imputed interest costs on the incremental loan. The correct interest rate is the overdraft rate since this represents the incremental cost the company will pay. Simple interest charges for three months are therefore: (3/12) $20,000 18% = $900. Question 6 KOBRIN ENGINEERS LTD WORKING TW Profit + Fixed costs = Contribution 35 325 360 VE 55 465 520 Product EC 30 270 300 SE 55 485 540

(i) Steel in short supply Contribution Steel costs Contribution/key factor Rank Production (units) Steel used

TW $360 $250 $1.44 2

VE $520 $500 $1.04 4

EC $300 $190 $1.58 1

SE $540 $390 $1.38 3

TW

VE

EC

SE

Special order Remaining sales of EC Remaining sales of TW Remaining sales of SE

31,000 51,300 67,500 70,200 220,000

30

20

30 270

20

270 180

Balance of steel on VE Total steel available Total production

30,000 250,000 300

60

80

300

200

(ii)Components in short supply TW Contribution Components Contribution/key factor Rank Production (units) Components TW Production (units) Special order Sales of SE Remaining components Total components available Total production 100 180 280 120 400 30 140 30 200 30 VE 20 EC 30 SE 20 180 $360 1 $360 3 VE $520 1 $520 2 EC $300 1 $300 4 SE $540 1 $540 1

120

(iii) Labour in short supply TW Contribution Labour hours Contribution/key factor Rank Production (units) Hours $360 15 $24 2 VE $520 15 $34.67 1 EC $300 12.5 $24 2 SE $540 25 $21.60 4

Special order Remaining hours Total hours Total production (iv) Make or buy Contribution if made Contribution if bought in

1,625 2,625 4,250

30 175

20

30

20

30

195

30

20

$ 360 285 75 15 5 Hours 1,625 2,625 4,250 30 175 205 95 300

$ 520 475 45 15 3

$ 300 250 50 12.5 4

$ 540 490 50 25 2

Extra contribution if made Labour hours Extra contribution/labour hours Rank Production (units) Special order Remaining hours Total hours Made in-house total Sub-contracted the differrence Total made and sold

20

30

20

20 180 200

30 270 300

20 180 200

Question 7 - XY AND ABC (a) Linear programming model Let x be the quantity of Product X Let y be the quantity of Product Y for the relevant period. Assuming that fixed costs are totally unaffected by production mix, the objective function is: Maximise contribution P = 5.50x + 6.50y subject to: 0.4x + 0.3y 2,200 (Mat A) 0.2x + 0.5y 2,500 (Mat B) x, y 0 (b)Optimal production plan One feasible solution is where both Materials A and B are used to the limit. equations become: 0.4x + 0.3y = 2,200 0.2x + 0.5y = 2,500 Solving: y = 4,000 substituting for y x = 2,500 feasible solution is: Product X 2,500 units Product Y 4,000 units Under such a situation the simultaneous

Contribution would be: $ Product X 2,500 5.50 =13,750 Product Y 4,000 6.50 =26,000 39,750 Question 8 BIL MOTOR COMPONENTS PLC a. Lowest selling price Machine Group

Per unit

Group 1 $

Group 7 $ 21.82 2.5 19.32 0.03 19.35

Group29 $ 3.05 1.5 1.55 0.02 1.57

Assembly $ 5.4 0.84 4.56 4.56

Total $

Total cost Less: Fixed overheads

31.65 3 28.65

Setting Variable cost

0.05 28.7

54.18

The lowest possible price would be that which covers the whole of the variable cost i.e. (200 54.18) = $10,836 per batch of 200 Evaluation of policy This price would not be making any contribution towards the recovery of the fixed overheads. If the company is to make a profit, it has to recover its fixed overheads. The selling price cannot really be set simply by reference to the variable costs. The prices at which competitors are offering the same product, plus engaging in market research should also be considered. Of particular importance are the likely reactions of competitors (e.g. if the strategy starts a price war the company could lose more than it gains). BIL should consider the possible impact on business if other customers of the product find out about the special price. This kind of strategy takes time to introduce. It could, in fact, be a number of years before the company can charge the customer the full price. Maximising profits For outputs and sales up to 7,000 units $ Selling price Less: Variable cost Contribution For outputs and sales over 7,000 units $ Selling price 11 $ 10 $ 9 13 6.2 6.8 $ 12 6.2 5.8 $ 11 6.2 4.8 $ 10 6.2 3.8 $ 9 6.2 2.8

Less: Bought-out finished price Contribution

7.75 3.25

7.75 2.25

7 2

Selling priceVolume units per unit

Contribution

Total contribution

$ 13 12 11 5,000 6,000 7,000 200 6.8 5.8 4.8 3.25

$ 34,000 34,800

33,600 650 34,250

10

7,000 4,200

3.8 2.25

26,600 9,450 36,050

7,000 6,400

2.8 2

19,600 12,800 32,400

(c) Ways in which management can increase production capacity Improving product design so that the production process can be simplified and take up less time. Improving plant lay-out, production methods and production scheduling, to reduce idle time and avoid bottlenecks. Introducing overtime working and/or shift working, if this has not already been done, to make more production time available. Introducing or improving an existing incentive scheme which makes use of the standard costing system, to enhance productivity. Buying certain components from outside suppliers rather than manufacturing them, which frees machines and equipment for other purposes. Employing sub-contracting manufacturers to produce completed products which also frees production facilities. Question 9 SALES VOLUME

Volume 000 units 2,1105 2,6775

Sales $000 5,825 6,774

Direct costs $000 1,904 2,415

Overheads $000 3,699 3,881

Total costs $000 5,603 6,296

Profit $000 222 478

3,150 3,591

7,245 7,433

2,841 3,182

4,032 4,173

6,873 7,355 0

372 78

3,9375 7,245 3,409 4,284 7,693 -448 (iii) Advice The analysis indicates that an increase in selling price of about 10% is justified as profit would be expected to increase. Question 10 POINTDEXTRE LTD (a) Using the high-low method: Units High Low Net 120,000 (W1) 102,000 18,000 Total cost $ 700,000 619,000 81,000

WORKING (1) Full capacity = 102,000 085 = 120,000 (i) Variable cost per unit = 81,000 18,000 = $450 (ii) Total fixed costs = 700,000 (120,000 450) = $160,000 (iii)Selling price per unit = variable cost per unit (100 040) = 450 06 = $750 (iv) Contribution per unit = (750 450) = $300 (b) New business: $ per unit 600 (450) 150 $ 22,500 (7,500) 15,000

Selling price (080 750) Less variable cost Contribution Contribution from 15,000 units (15,000 150) Less opportunity cost (15,000 6) $300 Net increase in contribution (and profit)

(c)An opportunity cost is the cost of the best alternative forgone in a situation of choice. Opportunity costs are relevant costs. In the situation of Pointdextre Ltd, if it goes ahead with the new business (that is the decision) then it will lose (forgo) the contribution from some existing sales. This lost contribution is an opportunity cost relevant to the decision. Question 11 ELLA LTD (a) (i) Initial selling price = (variable + fixed cost per unit) + mark up of 40% = [$4 + $(18,000 3,000)] 140 = $14 (ii) Profit = 3,000 units $4 profit per unit = $12,000 (b) Profits are maximised when: Marginal cost (MC) = Marginal revenue (MR) MC = variable cost = 4 MR = 20 0004Q 4 = 20 0004Q Q = 4,000 units P = 20 0002 (4,000) = $12 = profit maximising price. (c)

A penetration price is an initially low selling price of a product, whereas a skimming price policy is one where the initial selling price is set high. Question 12 BUDGET BEHAVIOUR (a) Purposes of budgets Planning The budget is a major short-term planning device placing the overall direction of the company into a quarterly, monthly and, perhaps, weekly focus. It ensures that managers have thought ahead about how they will utilize resources to achieve company policy in their area. Control Once a budget is formulated a regular reporting system can be established so that the extent to which plans are, or are not, being met can be established. Co-ordination As organizations grow the various departments benefit from the co-ordination effect of the budget. In this role budgets ensure that no one department is out of line with the action of others. They may also hold in check anyone who is inclined to pursue his or her own desires rather than corporate objectives. Communication The construction of the budget can be a powerful aid to defining or clarifying the lines of horizontal or vertical communication within the enterprise. Managers should have a clearer idea of what their responsibilities are, what is expected of them, and are likely to work better with others to achieve it. Performance Evaluation When budgets are tailored to a department or manager they become useful tools for evaluating how the manager or department is performing. If sales targets are met or satisfactory service provided within reasonable spending limits then bonus or promotion prospects are enhanced. Motivation The value of a budget is enhanced still further if it not only states expectations but motivates managers to strive towards those expectations. This is more likely achieved if a manager has had some involvement in the budget construction, understands its implications and agrees it is fair and controllable by him/her. (b)Behavioural factors If budgetary control is to be successful, attention must be paid to behavioural aspects, i.e. the effect of the system on people in the organisation and vice versa. The following are some of the points which should be borne in mind: Budget target The existence of some form of target is a greater motivation than no target at all. The establishment of a target, however, raises the question of the degree of difficulty or challenge of the target. If the performance standard is set too high or too low then sub-optimal performance could be the result. Some people respond positively to a difficult target others, if challenged, tend to withdraw their commitment. Performance Evaluation The emphasis on achievement of budget targets can be increased, but also the potential for dysfunctional behaviour, if the budget is subsequently used to evaluate performance. This evaluation is frequently associated with specific rewards such as remuneration increases or improved promotion prospects. In such cases it is likely that individuals will concentrate on those items which are measured and rewarded neglecting aspects on which no measurement exists. This may result in some aspects of the job receiving inadequate attention because they are not covered by goals or targets due to the complexity of the situation or the difficulty of measurement. Managerial Style The use of budgets in evaluation and control is also influenced by the way they are used by the superior. Different management styles of budget use have been observed, for example: budget constrained placing considerable emphasis on meeting budget targets profit conscious where a balanced view is taken between budget targets, long-term goals and general effectiveness. non-accounting where accounting data is seen as relatively unimportant in the evaluation of subordinates. The style is suggested to influence, in some cases, the superior/subordinate relationship, the degree of stress and tension involved and the likelihood of budget attainment. The style adopted and its implications are affected by the environment in which management is taking place. For example, the degree of interdependency between areas of responsibility, the uncertainty of the environment and the extent to which individuals feel they influence results are all factors to consider in relation to the management style adopted and its outcomes. The use of performance measures to measure output and quality Where output for a NFP organisation can be quantified, targets can be set and performance against these targets can be measured. In a university, for example, targets could be set in terms of the number of students graduating

with a first-class degree, the number of students in a tutorial group, and the percentage of students who complete a degree course having started it. Information could easily be gathered to enable an assessment of the Universitys performance compared to agreed, budgeted or imposed targets. Measuring performance in terms of quality is not so easy. It may be possible to use a surrogate or substitute performance measure if a quality cannot be directly measured. For example, the efficiency of hospital outpatient treatment could be measured by the average length of the queue for treatment. The quality of a University course could be assessed by a composite weighting of responses to individual student questionnaires.

Participation It is often suggested that participation in the budget process and discussion over how results are to be measured has benefits in terms of budget attitude and performance. Views on this point are varied however, and the personality of the individuals participating, the nature of the task and the organization structure influence the success of participation. But a budget when carefully and appropriately established can extract a better performance from the budgetee than one in which these considerations are ignored. Bias Budget holders who are involved in the process from which the budget standards are set are more likely to accept them as legitimate. However, they may also be tempted to seize the opportunity to manipulate the desired performance standard in their favour. That is, they may make the performance easier to achieve and hence be able to satisfy personal goals rather than organizational goals. This is referred to as incorporating slack into the budget. In this context there may be a relationship between the degree of emphasis placed on the budget and the tendency of the budgetee to bias the budget content or circumvent its control. Any organizational planning and control system has multiple objectives but primary amongst these is encouraging staff to take organizationally desirable actions. It is never possible to predict with certainty the outcomes of all behavioural interaction however it is better to be aware of the various possible behavioural implications than to be ignorant of them Question 14 ALL PREMIER SERVICES PLC (a)(i) X Number of beds Fee per bed per night $ Assumed occupancy % Occupied beds Budgeted profit and loss statement per week X Income 225 x 39 x 7 days Variable costs 61425/159775 x 42412 Fixed costs 60/145 x 127300 Total costs Income less costs Cost per occupied bed 68981/39 61,425 16,305 52,676 68,981 7,556 1,769 Y 44,800 11,892 35,117 47,009 2,209 1,469 Z 53,550 14,215 39,507 53,722 172 1,194 Total 159,775 42,412 127,300 169,712 9,937 60 225 65 39 Y 40 200 80 32 Z 45 170 100 45 total 145

(ii)

X Number of beds Fee per bed per night $ Assumed occupancy % Occupied beds Budgeted profit and loss statement per week X Income Variable costs Fixed costs Total costs Income less costs Cost per occupied bed 75,600 20,068 43,646 63,714 11,886 1,327 60 225 80 48

Y 40 200 95 38

Z 75 170 100 75

Y 53,200 14,122 29,097 43,219 9,982 1,137

Z 89,250 23,691 54,557 78,248 11,002 1,043

Total 218,050 57,881 127,300 185,181 32,869

(b)Ward Z patients from wards X and Y The patients in ward Z are existing patients and do not represent new admissions. For that reason, ward Z only exists as a further outlet for wards X and Y. This implies a degree of dependency in operations. Decisions concerning ward Z cannot therefore be separated from the decisions concerning wards X and Y. It may well be the case that, given the hospital is private and presumably subject to competition, patients may choose All Premier Services because of the facilities offered in ward Z that might not be available elsewhere. The relevance of the allocation bases Given that fixed overheads must be incurred irrespective of occupancy then the fact that unoccupied beds are allocated costs irrespective of occupancy is probably the correct approach. On the other hand, variable overheads are allocated on a fee earned per bed basis. The incorporation of fees into the allocation of variable overheads might reflect the fact that wards X and Y deal with patients with different medical conditions and costs. The fees charged by the hospital reflect this fact. The adjustment for occupancy through the fees earned allocation base reflects the fact that variable overheads relate directly to resource use when beds are occupied. For this reason, it is probably an appropriate allocation base. Question 15 BUDGETING & COSTING-not-for-profit organization (a) Not-for-profit (NFP) organizations such as charities deliver services that are usually limited by the resources available to them. It may be not be possible to express their objectives in quantifiable or measurable terms, or to measure their output in terms of the services they deliver. The financial focus in NFP organizations is therefore placed on the control of costs. Selection of cost units A cost unit for a NFP organization is a unit of service for which costs are ascertained. These cost units will be used to assess the efficiency and effectiveness of the organization. The problem for a NFP organization is that it may not have easily identifiable cost units, and it may not be possible to identify costs with specific outputs. Once appropriate cost units have been identified, however, they can be used to provide cost control information. Examples of costs units used by an NFP organization are patients, wards, drug treatment programmes, bed- nights and operations, which are all used by a hospital. The use of performance measures to measure output and quality Where output for a NFP organization can be quantified, targets can be set and performance against these targets can be measured.

In a university, for example, targets could be set in terms of the number of students graduating with a first-class degree, the number of students in a tutorial group, and the percentage of students who complete a degree course having started it. Information could easily be gathered to enable an assessment of the Universitys performance compared to agreed, budgeted or imposed targets. Measuring performance in terms of quality is not so easy. It may be possible to use a surrogate or substitute performance measure if a quality cannot be directly measured. For example, the efficiency of hospital outpatient treatment could be measured by the average length of the queue for treatment. The quality of a University course could be assessed by a composite weighting of responses to individual student questionnaires. Comparison of planned and actual performance NFP organisation will have a budget that details expected levels of income (for example from donations and investments) and expenditure (for example on staff wages, continuing programmes, fixed overheads and planned purchases). The use and application of costing principles and information here is no different than in a profit-making organisation. Planned performance can be compared to actual performance, income and cost variances calculated and investigated, and corrective action taken to remedy under-performance. Where objectives cannot be specified in terms of quantifiable targets, costing information will serve no purpose and assessment of actual performance with planned performance will need to be undertaken from a more subjective perspective. Question 16 LEANO PLC

(a) Sales units (10000x 6) , (10000x12) Sales revenue (1) Costs: Direct material (2) Direct labour (3) Variable overhead (4) DAFC Net cash inflow

6 month 60,000 $ 720,000 271,000 191,340 76,536 90,000 628,876 91,124

12 month 120,000 $ 1,260,000 514,000 315,423 126,169 180,000 1,135,592 124,408

Required cash inflow for target return: $75,000 + 33.33% $100,000 $75,000 + 50% The target return will be achieved over a 12 month life cycle.

$112,500

Sales for six months and 12 months are at $1,200 and $1,050 per batch of 100 units 1 respectively. 2 Direct material: batches 200 $500 200 $450 $ 100,000 90,000

200 $405 for six months 600 $405 for 12 months


WORKING NOTES: (3) Direct labour: For first six months: y = axb = 2,500 600-0.3219 = $318.90 Hence total cost = $318.90 600 batches = $191,340 For seven months: y = axb = 2,500 700-0.3219 = $303.461 Hence total cost = $303.461 700 batches = $212,423 All batches after the first 700 will have the labour cost of the 700th batch. For 699 batches: y = axb = 2,500 699-0.3219 = $303.601 Hence total cost = $303.601 699 batches =$212,217 Cost of 700th batch = $212,423 $212,217 = $206 Total cost for 12 months = $212,423 + ($206 500) = $315,423 (4) Variable overhead is $2 per hour i.e., 40% of direct labour.

81,000 271,000 243,000 514,000

(b) Variable overhead is dependent on labour cost. To achieve the target return of $ 100,000 in the six months, labour and overhead must be reduced by the current shortfall of $8,876. Maximum labour and overhead = $259,000 Let y = average labour cost per batch of product We require 1.4 600 y = $259,000 Solving y = $308.333 Now learning curve is y = axb Substituting 308.33 = a 600-0.3219 a= $2,417 (approx) Hence initial batch labour hours = $2,417/$5 = 483.4 hours (approx) c. Report on new product proposal (i) The proposal for the new short life product X is an example of target costing in that: the market has been identified in terms of quantity and price the required rate of return over the life of the product has been set the need to ensure that costs can be restructured in order to provide the required return over six months has been evaluated. (ii) A number of specific actions may be considered in order to improve the return on investment: reduce the initial labour cost per batch by examination of the production process with a view to the elimination of unnecessary operations. improve the learning curve rate, possibly by additional training or change in the method of production reduce the material losses in the early batches prior to the steady state being reached examine the variable overhead element which is being absorbed per labour hour. Are labour hours the sole and/or most relevant cost driver?

investigate whether the $15,000 per month of DAFC contains any non-value added overheads which may be eliminated investigate whether any of the DAFC may be sourced more cheaply. (iii) All of the above must be considered taking into account the need to provide a product of the agreed design specification and performance, otherwise free replacement of faulty units to the customer and/or warranty claims may reduce the return from the product. A person Management Accountant June1996 Question 18 VELO RACERS (a) Learning Curve Theory is concerned with the idea that when a new job, process or activity commences for the first time it is likely that the workforce involved will not achieve maximum efficiency immediately. Repetition of the task is likely to make the people more confident and knowledgeable and will eventually result in a more efficient and rapid operation. Eventually the learning process will stop after continually repeating the job. As a consequence the time to complete a task will initially decline and then stabilise once efficient working is achieved. The cumulative average time per unit is assumed to decrease by a constant percentage every time that output doubles. Cumulative average time refers to the average time per unit for all units produced so far, from and including the first one made.

No of Bikes

Cumulative Average Time (hours)

Total Time To Date (hours)

Incremental Time for Additional Bikes (hours)

50

50

2 ( 08)

40

( 2)

80

(80 50)

30

4 ( 08)

32

( 4)

128

(128 80)

48

8( 08)

25.6

( 8)

204.8

(204.8 128)

76.8

Quotation 1

Materials

1,000

Labour (30 10)

300

Overheads

600

Total cost

1,900

Profit (20%)

380

Selling Price

2,280

Quotation 2

Materials

2,000

Labour (48 10)

480

Overheads

960

Total cost

3,440

Profit (20%)

688

Selling Price

4,128

4,128/2 = $2,064 Per Bike

Quotation 3 Materials Labour (2048 10) Overheads Total cost Profit (20%)

$ 8,000 2,048 4,096 14,144 2,8288

Selling Price 16,9728/8 = $2,1216 Per Bike

16,9728

(c) Areas of consequence A standard costing system would need to set standard labour times after the learning curve had reached a plateau. A budget will need to incorporate a learning cost factor until the plateau is reached. A budgetary control system incorporating labour variances will have to make allowances for the anticipated time changes. Identification of the learning curve will permit the company to better plan its marketing, work scheduling, recruitment and material acquisition activities. The decline in labour costs will have to be considered when estimating the overhead apportionment rate. As the employees gain experience they are more likely to reduce material wastage. Limitations: The stable conditions necessary for the learning curve to take place may not be present unplanned changes in production techniques or labour turnover will cause problems and affect the learning rate. The employees need to be motivated, agree to the plan and keep to the learning schedule these assumptions may not hold. Accurate and appropriate learning curve data may be difficult to estimate. Inaccuracy in estimating the initial labour requirement for the first unit. Inaccuracy in estimating the output required before reaching a steady state time rate. It assumes a constant rate learning factor. Answer 19 STANDARD COSTING Standard costing has been employed for many years in situations where there is a significant degree of repetition in the production process or the service supplied. Repetition is a condition since standards presuppose that averages, as expected values, are accurate to a fair degree. The main uses of standard costing relate to: 1. Valuation of inventory and costs of production for reporting purposes, either internally or for statutory reasons. 2. Providing an excellent management device which enables costs to be monitored, reviewed and controlled. 3. Enabling exception reporting through the use of variance analysis. Exception reporting allows management to exercise control with a lower degree of effort and less time than otherwise would be the case. 4. Assisting in the budgeting process. Standards, once established in a business, become the common language by which performance is discussed and measured. 5. Evaluating managerial performance. 6. Motivation of staff by setting standards at levels to which staff feel able to respond. In this respect, standards have been characterized as ideal, attainable, current, and basic as a way of categorizing the different ways standards may be viewed in terms of their motivational impact. 7. Improving efficiency. Standard setting is often viewed as a way of understanding the detail of a process through monitoring its important components. If standards are an accurate reflection of a process, then they can be used to highlight ways of improving efficiency and act as signals when the process becomes inefficient. Once standards have been set they cannot be assumed to be accurate over long periods of time. Standards have to be reviewed to enable the benefits of standard costing to continue. In this respect, standards must change with the changing practices of an organization. For example, in environments which continuously seek greater efficiency and reduced costs of production, standards have to change to reflect such improvements. In fact, under such circumstances, standards can very quickly become out of date. In order to review standards, they must be continually assessed to ensure that the basis of their calculation still applies. Moreover, other purposes of standards are undermined if they are not continually reviewed. Thus, for example: 1. The motivational impact of standards may no longer be effective if standards are out of date. 2. Assessment of managerial performance becomes inaccurate. 3. Reporting procedures are undermined. 4. The credibility of standards in their role in assisting with the budget setting process is called into question. 5. The fate of standard costing as a management tool is put at risk if management do not trust the standards. Alternative mechanisms for management control inevitably emerge which may be undesirable, untested and lack organisational approval. Question 20 INFORMATION SOURCE Purposes of standard costing A standard costing system can support a wide range of management requirements. For example: It can help in the development of budgets; standards are in effect the building blocks of periodic budgets.

standard can act as a target and hence become a source of employee motivation standard costs are the basis for measuring performance The variances that are derived from standard costs act as a control device by highlighting those activities which are different from plans. This signals to decision makers the need for action to take advantage of any circumstances which have produced favourable variances or minimise the repercussions of any adverse variances. Standard costs are predicted future costs which can be used to support decision making, for example in making pricing decisions. In manufacturing companies a key requirement of costing is the valuation of inventory. Standard costs simplify the process of tracing costs to products for inventory valuation.22 (b) Different levels of performance 1. Basic standards such standards are left unchanged for a long period, perhaps from the inception of the product or service concerned. They may be useful in demonstrating a progression of improved performance over a period of time, but do not represent current targets. Therefore, they do not motivate, they do not result in representative unit costs and are inappropriate as predicted costs for decisions. Ideal standards these represent perfect performance and the most efficient operating conditions reflecting the lowest possible costs. They are a useful objective to which the firm can aspire over the long term but firms will rarely achieve this level of performance consistently. As a result adverse variances will almost always be reported, this will inevitably have an adverse effect on employee attitude and motivation. They represent budget figures which are too tight and inappropriate from which to set prices or to use directly as performance measures in most circumstances. 3. Currently attainable standards these standards represent costs which should be attained under current efficient operating conditions. They are a reasonable target and represent a likely level of future costs if operations are managed efficiently. They are a level of performance which does not demotivate staff. They are therefore the figures which can be used to manage the current operations of a business unit. They are figures which can support planning and decision-making and as current cost levels they are appropriate for inventory valuation. It should be expected that most companies will run their systems based on these standards. The first two levels mentioned above may, on the other hand, be useful for strategic purposes, demonstrating on an ad hoc basis, how far the company has come or how far it has to go. (c) Standard costing application Standard costing is most suited to organisations whose activities consist of a series of common or repetitive operations. Typically, mass production manufacturing operations are indicative of its area of application. It is also possible to envisage operations within the service sector to which standard cost may apply, though this may not be costed with the same degree of accuracy of standards which apply in manufacturing. In modern manufacturing and service businesses, continuous improvement and cost reduction are topical. In order to remain competitive it is essential that businesses address the cost levels of their various operations. To do this they have to deal with the costing of operations. But the drive to cost down may mean in some cases that standards do not apply for long before a redesign or improvement renders them out of date. In such a setting an alternative to the use of standard costs is to compare actual costs with those of the previous operating period. We have seen in (a) above that a standard costing system has a variety of purposes. It is for management to judge their various reasons for employing standard costing, and consequently whether their aims of continuous improvement and cost reduction render the system redundant. Question 21 CARAT PLC Budgeted gross profit Budgeted fixed production overhead Budgeted contribution (50,000 325) Sales volume contribution variance Sales price variance Actual sales ($580,800) less standard variable cost of sales Variable cost variances (F) Material A price 7,317 Material B price Material A mix Material B mix 4,478 Material A yield 3,027 100,000 62,500 162,500 6,500 (A) 4,800 (F) 1,700 (A) 160,800 (A) 3,360 6,344

Material B yield Labour rate Idle time Labour efficiency Actual contribution Budgeted fixed production overhead Fixed production overhead expenditure variance Actual fixed production overhead Actual gross profit

1,282 1,920 1,800 16,200 32,304 13,424 62,500 1,500 (A) 64,000 115,680 18,880 (F) 179,680

(d) The theory of motivation suggests that having a clearly defined target results in better performance than having no target at all, that targets need to be accepted by the staff involved, and that more demanding targets increase motivation provided they remain accepted1. It is against this background that basic, ideal, current and attainable standards can be discussed. A basic standard is one that remains unchanged for several years and is used to show trends over time. Basic standards may become increasingly easy to achieve as time passes and hence, being undemanding, may have a negative impact on motivation. Standards that are easy to achieve will give employees little to aim at. Ideal standards represent the outcome that can be achieved under perfect operating conditions, with no wastage, inefficiency or machine breakdowns. Since perfect operating conditions are unlikely to occur for any significant period, ideal standards will be very demanding and are unlikely to be accepted as targets by the staff involved as they are unlikely to be achieved. Using ideal standards as targets is therefore likely to have a negative effect on employee motivation. Current standards are based on current operating conditions and incorporate current levels of wastage, inefficiency and machine breakdown. If used as targets, current standards will not improve performance beyond its current level and their impact on motivation will be a neutral one. Attainable standards are those that can be achieved if operating conditions conform to the best that can be practically achieved in terms of material use, efficiency and machine performance. Attainable standards are likely to be more demanding than current standards and so will havea positive effect on employee motivation, provided that employees accept them as achievable. Question 22 LINSIL 2 (a) Revised standard costs: $ Selling price Materials: usage per unit (3 kg 0.95) Materials price per kilo($2.3 1.03) Material cost per unit Labour usage per unit (1.25/0.9) Labour rate per hour ($12 1.04) Labour cost per unit Revised standard contribution per unit 1.38 12.48 17.22 7.53 2.85 2.369 6.75 $ 31.5

(b)

Statement reconciling original budgeted contribution with revised budgeted contribution Original budgeted contribution (120,000 units 9.6) Add: Reduced materials costs due to revision of standard ($6.9 $6.75) 120,000 units Less: Increased labour costs due to revision of standard: ($15 $17.22) 120,000 units Revised budgeted contribution (120,000 units x 7.53) (c) Statement reconciling revised budgeted contribution with actual contribution Favourable Variances $ Revised budget contribution Sales price variance Sales volume variance Materials price variance Materials use variance Labour rate variance Labour efficiency variance 121,512 150,822 Actual contribution WORKINGS 1 Sales price variance: Actual quantity, actual price Actual quantity, standard price (122,000 31.5) 111,118 14,250 19,032 15,060 31,086 61,000 Adverse variances $

$ 1,152,000

18,000

-266,400 903,600

$ 903,600

39,704 943,304

$ 3,782,000 3,843,000

61,000 (A) 2 Sales volume variance Actual sales (units) Budgeted sales (units) $ 122,000 120,000 2,000 standard contribution per unit $7.53 Sales volume variance 3 Materials price variance Actual quantity actual price Actual quantity standard price (341,600 kg $2.369) Materials price variance 4 Materials usage variance Actual quantity x standard price Standard quantity for actual output x actual price (122,000 units $6,75) Materials usage variance 5 Labour rate variance Actual hours actual rate Actual hours standard rate (158,600 $12.48) Labour rate variance 6 Labour efficiency variance Actual hours x standard rate Standard hours for actual output x standard rate (122,000 units $17.22) Labour efficiency variance 2,100,840 121,512(F) 823,500 14,250 (F) $ 1,998,360 1,979,328 19,032(A) $ 1,979,328 15,060(F) $ 840,336 809,250 31,086(A) $ 809,250

(d)Variance analysis is used to assess the performance of various managers involved in the purchasing and production process. Their performance is compared to a target, the standard cost, and any differences between actual and standard will be considered to be the responsibility of the manager. The controllability principle is that managers should only be judged on things they have control over. Where standards turn out to be unrealistic, due to changes which are outside of the control of the managers, they do not reflect accurately the performance of the managers. Standards should therefore be revised for uncontrollable factors before variance analysis is performed. The risk of revising variances is that managers may be tempted to include inefficiencies in the revised standard to reduce any adverse variances, which may be due to internal factors. Variances should not be revised to include internal, controllable factors or inefficiencies.

In practice, there is likely to be some discussion of whether a change should be included in the revision of a variance or not. It is important therefore that all revisions are authorised by a senior, independent body, such as a budget committee before being used for variance analysis. This should ensure that changes made are fair and reasonable. (e) The following factors could be discussed. Size Larger cost savings are likely to arise from taking action to correct large variances and a policy could be established of investigating all variances above a given size. Size can be linked to the underlying variable in percentage terms as a test of significance: for example, a policy could be established to investigate all variances of 5% or more. Adverse or favourable It is natural to concentrate on adverse variances in order to bring business operations back in line with budget. However, whether a variance is adverse or favourable should not influence the decision to investigate. The reasons for favourable variances should also be sought, since they may indicate the presence of budgetary slack or suggest ways in which the budgeting process could be improved. Favourable variances may also indicate areas where the budget is easy to achieve, suggesting that the motivational effect of a budget could be improved by introducing more demanding targets. Cost versus benefits If the expected cost of investigating a variance is likely to exceed any benefits expected to arise from its correction, it may be decided not to investigate. Historic pattern of variances A variance which is unusual when compared to historic patterns of variances may be considered worthy of investigation. Statistical tests of significance may be used to highlight such variances. Reliability and quality of data If data is aggregated or if the quality of the measuring and recording system is not as high as would be liked, there may be uncertainty about the benefits to arise from investigation of variances. Question 23 AVX PLC (a) Calculation of learning rates The first step in solving this problem is to calculate the actual cost of output for each period. This is done by calculating the standard cost, and then deducting favourable efficiency variances from this to find actual cost. Batches OfStandard output cost $ November December January February March April 1 1 2 4 8 16 500 500 1,000 2,000 4,000 8,000 Variance Actual cost $ 0 170 452.2 1089.3 $ 500 330 547.8 910.7

1,711.50 2,288.50 3423 4,577.00

The next stage is to calculate the cumulative average cost each month- that is total costs to date since the first product was made. Cumulative average cost per unit can also be calculated

Cumulative

Cumulative

Cumulative

Batches Produced

Total costs

Average cost per Unit

$ November December January February March April 1 2 4 8 16 32

$ 500 830 1377.8 2,288.50 4,577.00 9,154.00

$ 500 415 344.45 286.06 286.06 286.06

The table shows that as cumulative output doubles, from 1 to 2 units, cumulative average cost per unit falls to 83% of the average cost for the first unit. This is repeated each time cumulative output doubles until cumulative output reaches 8 batches. After this, cumulative average cost per unit remains constant, meaning that the learning rate has ceased. The learning rate was therefore 83% for the period November to February. After this it was zero Question 25 EATWELL RESTAURANT (a) The performance can be categorised into the following key areas: Financial, Competitiveness, Resource Utilisation, Quality of Service and innovation/Flexibility. Financial: continuous turnover growth with a 123% increase over the period. Annual compound growth rate an even faster growth in profit approximate five fold increase profits growing faster than turnover creates an increasing net profit margin from 14% in 1998 to 309% in 2001. This may have arisen from improved resource utilisation (see below) resulting in a gradual decrease in the ratio of fixed costs to revenues. Competitiveness: Concerned with market share and growing new business areas. Market share measured by the rate of restaurant turnover to the turnover of all restaurants in the locality. This commences with 92% in 1998 and continually increases to 175% in 2001. There is also a rapid growth in the proposals submitted for new events (10 to 38), and even more significantly, is the faster growth in contracts won. The success rate increases from 20% in 1998 to 66% in 2001. The restaurant is therefore competing increasingly successfully in this developing business area. The restaurant is becoming increasingly price competitive. Quality of service The increasing number of regular customers would suggest that many customers are satisfied with the total package that the restaurant offers. This may be partly due to service quality or other factors such as price competitiveness. The growth in complaints, complimentary letters, reported cases of food poisoning and the service delivery data would suggest rather a mixed situation. It is difficult to provide a definitive comment regarding the quality of service over the period, especially as the number of customers nearly doubled over the period. Even additional calculations, such as those involving key service quality data per 100 customers would not provide the basis for an overall conclusive comment Innovation/Flexibility The restaurant has fared quite well in this respect when we consider: increase in the number of dishes on offer the introduction of theme evenings

the development of the catering activities for special events The restaurant is prepared to try new dishes although the extent of its experimentation varies considerably from year to year. Also, the fluctuating and somewhat unsatisfactory service delays suggest that they are not managing to flex their resources adequately to meet peak demand levels. Resource Utilisation The business activity level continually increased over the period (meals served) with a decline in non-productive time and the hours of operation with no customers. All these suggest an improvement in resource utilisation. We do not know whether the increase in seating capacity in 2000 arose from extending the floor area available or from the provision of more seating within a constant space. Although this capacity increase permitted more customers to be fed at peak times, it did result in a fluctuation in the annual number of meals served at each seat, 150 (1998), 204 (1999), 155 (2000), 167 (2001). A brief attempt was made in 2000 to extend the opening hours and increase the hourly utilisation of the premises (b) Financial: The value of assets required to generate the profits to calculate the ROCE details of cost categories e.g. labour, food overheads to assess comparative financial ratios did the increase in capacity in 2000 require additional capital investment to assess the marginal returns the level of business risk inherent in alternative business and the associated expected return Competitiveness national trends in restaurant attendance and revenues provide broader comparisons data on/customer surveys of restaurants in targeted customer groups Quality of Service to assess various intangible factors e.g. politeness of staff, atmosphere and dcor, responsiveness to customer requests food writers or expert ratings Innovation/Flexibility: staff training and the potential for multi-skilled activities to provide greater operational flexibility the ability to cope with non-standard requests e.g. special dietary needs and respond to customer needs Resource Utilisation data on employee numbers would facilitate the calculation of business activity per employee data on floor area per customer Question 27 OSBORNE LTD (a) Performance targets (i) Divisional return on investment Traceable profit/Traceable capital employed Traceable profit = 8.5m 5.3m 1.7m 0.95m = 0.55m Capital employed = 2m + 1.2m + 0.3m + 0.8m + 0.5m + 0.1m 0.4m 0.2m = 4.3m Therefore ROI = 0.55/4.3 = 12.8% (ii) Divisional residual income (assuming an imputed interest rate of 12%) $m Traceable profit 0.550 Imputed interest (12% 4.3m) (0.516) 0.034 Thus both targets have been achieved. (b)Mr Iommi Given that Mr Iommi is due to retire after the projects first year, he will only consider the effect on ROI and RI for the first year. The effect during year 1 on the companys profit and capital is as follows: $ Profit Cash flow from project 300,000 Depreciation (840,000/3) (280,000) Increase in profit 20,000 Capital employed after one year increase in capital employed will be the NBV of the investment = 840,000 280,000 560,000 New ROI (0.55 + 0.02)/(4.3 + 0.56) New RI Traceable profit (0.55 + 0.02) Imputed interest (12% 4.86) $m 0.570 (0.583) (0.013) 11.7%

Hence neither target is achieved and Mr Iommi would not receive his bonus for 2000 Note Over the whole life of the project average net profit is [(300,000 + 600,000 + 700,000) 840,000] = $253,333 Thus ROI for the project calculated as Average annual profit/Net assets at end of first year = 253,333/ 560,000 100% = 45.2% and RI for the project in global terms = 253,333 (12% 840,000) = $152,533 If the project is considered over its entire life it would be acceptable under both appraisal measures. Consequently, Mr Iommi is acting dysfunctionally by not accepting the project. However, this is understandable given that Mr Iommi is concerned with short-term results rather than long-term, due to his intention to retire in a year. What has caused the difference in attitudes towards the project is the fact that the high profits occur after the first year of the projects life. Question 28 CP DIVISION Impact of accepting the contract Year 1 $000 Operating profits before depreciation $2.00m $1.35m Depreciation $1.5m 5 Net profit (1) Capital employed (beginning of year) Non current assets Working capital Total capital employed (2). Interest at 20% (on (2)) 1,500 500 2,000 400 1,200 500 1,700 340 900 500 1,400 280 600 500 1,100 220 300 500 800 160 650 -300 350 650 -300 350 650 -300 350 650 -300 350 650 -300 350 Year 2 $000 Year 3 $000 Year 4 $000 Year 5 $000

ROCE (1) (2) RI (1) (3) ($000)

17.50% -50

20.60% 25% 10 70

31.80% 43.70% 130 190

At present CP makes a ROCE of 30% and has RI of $1 million ($3m 20% of $10m). Therefore the contract is not likely to be attractive to CPs management, since: (i) the ROCE falls below the existing level for years 1 to 3 (ii) the total residual income will decrease in year 1 and only marginally increase in year 2. 29. Question 49 RESPONSIBILITY CENTRES (a) A responsibility centre is part of an organisation for whose activities a manager is deemed to be responsible. The type of responsibility centre depends on the type of activities for which responsibility is carried. Cost Centre A cost centre or expense centre can be defined as a responsibility centre where a manager is accountable only for costs which are under his control. It is a production or service location for which costs can be identified or accumulated prior to allocation to cost units. An example of a standard cost centre is a production unit within a factory. A cost centre manager is responsible for the cost of inputs to the organisation. The performance of the manager of a cost centre can be assessed by comparing actual performance with budgeted targets for price, usage and efficiency. Revenue Centre

A revenue centre is a responsibility centre where a manager is accountable solely for the revenue generation that is under his control. An example would be a sales team with a target geographical area which is under the control of a sales manager. The manager would have no responsibility for the production cost of the items his team is selling, but has responsibility for meeting sales targets in terms of sales volume, sales revenue or market share. A revenue centre manager has responsibility for the revenue generated by outputs from the organisation. The performance of the manager of a revenue centre can be assessed by comparing actual performance with budgeted targets for price, mix and volume. Profit Centre A profit centre is a combination of a cost centre and a revenue centre where a manager has responsibility for both production costs and revenue generation. The degree of responsibility carried by a manager can be higher with a profit centre than with a cost centre or a revenue centre, and the manager may be responsible for purchasing, production planning, product mix and pricing decisions. The performance of the manager of a profit centre is unlikely to be assessed on the fine detail of cost and revenue data but by the extent to which agreed targets for overall cost, revenue and profit have been achieved. Investment Centre With an investment centre, the manager of a profit centre is given additional responsibility for investment decisions regarding working capital and the purchase and replacement of fixed assets. The manager of an investment centre is likely to be assessed with an aggregate measure that links periodic profit to the assets employed in the period to generate that profit. An example of such an aggregate measure is return on capital employed. Controllable and Non-controllable Factors It is an important principle of responsibility accounting that managers can only be assessed on the cash flows that are under their control. If a manager has no control over a cash flow he cannot influence its size or timing and so cannot be held responsible if either of these values changes. The performance of the manager of a cost centre can thus only be assessed on the controllable costs over which he exercises control. In the case of a production cost centre, the manager may be able to control material usage but could have no influence over the price at which materials are bought by the purchasing department. For the production cost centre manager, material usage is a controllable factor whereas material purchase price is not. With a revenue centre, a sales manager can be held responsible for generating revenue against agreed sales volume targets but may have no control over the selling price of his products as this is determined by market conditions. In this case sales volume is a controllable factor whereas selling price is not. The manager of a profit centre will have control of operating costs but will not be able to influence the financing costs arising from investment decisions. The manager may thus have responsibility for operating profit but his performance should not be assessed on profit before tax since interest charges are outside of his control. The manager of an investment centre could have his performance assessed on profit before tax, but the profit on which he is assessed should exclude non-controllable elements such as overhead costs that he cannot influence, for example allocated head office charges. Return on investment = controllable profit as a percentage of capital employed. It is thus a relative, rather than an absolute, performance measure and is both widely used and understood. Controllable profit means that non-controllable factors are excluded as far as possible from the profit used in calculating ROI since these will diminish the usefulness of the calculated measure in assessing managerial performance. Because ROI is a relative measure, it can be used to compare performance between investment centres. ROI also offers a way of assessing the past investment decisions made by an investment centre, since it is measured after these investment decisions have been made. It can thus be used to check that the performance predicted by investment appraisal decisions is in fact being achieved post implementation. Since ROI assesses investment centre managerial performance on the basis of controllable profit generated, managers will be keen to maximise this as far as possible. The desire to maximise controllable profit can be assisted by the use of performance related pay and similar incentive schemes. But if performance is assessed using ROI, investment centre managers will be as keen to minimise capital employed as they will be to maximise controllable profit. While this can encourage managers to dispose of obsolete equipment and minimise working capital, it can also lead to sub-optimal decisions for the company as a whole. If managers are assessed using ROI, there will be a disincentive to invest in projects with a ROI that is less than the current ROI of the investment centre. However, these projects should be accepted if the project ROI is greater than the companys cost of capital. In this case, the decision not to invest will not be consistent with the overall objective of maximising shareholder wealth.

A similar problem arises with asset disposal decisions. Here, a manager assessed using ROI may choose to retain assets with a low written down value since these assets will generate a higher ROI than new, more expensive assets that could be more economical and efficient. This problem highlights the way in which short-term concerns can outweigh longer-term interests when ROI is used to assess managerial performance. It should be noted that ROI can simply increase due to ageing assets rather than from the actions of managers charged with increasing it. Residual income has been suggested as a way of overcoming some of the perceived shortcomings of ROI as a managerial performance measure. Residual income (RI) is defined as controllable profit less a cost of capital charge on controllable investment. RI is therefore an absolute, rather than a relative, performance measure, which means that comparisons between investment centres cannot be made directly. The advantage of RI as a performance measure is that the cost of capital charge is made by reference to the companys cost of capital. Investment centre managers assessed on the basis of RI will therefore choose to accept all projects with a positive RI, increasing the companys overall return. Investment centre managers will also be discouraged from retaining ageing and inefficient assets, since replacing such assets by more efficient ones is likely to lead to an increase in residual income. Overall, it is felt that return on investment is an unsatisfactory way of assessing managerial performance as far as an investment centre is concerned, and that residual income should be used instead. Despite this, ROI appears in practice to be preferred to RI. Question 30 EAGLESPORT LTD REPORT To : The Board of Directors, Eaglesport Ltd From: Barry Lineker, Management Accountant Date: 17 January 2010 Subject: Croydon branch performance Purpose of report To assess the performance of the Croydon branch and the present system of performance indicators- Return on Investment (ROI) and Residual Income (RI). To identify alternative performance indicators to assess branch performance. (a) Croydon branch performance The branch has operated to a 6.3% net profit margin compared to a budgeted 10%. This is possibly caused by poor cost control. Revenue is 8.2% below budget, yet costs are only 4.4% down on budget. It is not clear from the management accounts the split between fixed and variable costs and the control that the division has operated. The variable costs that the company incurred are likely to include casual labour, catering costs consumables, laundry costs etc. The extent of over/underspend is not clear from the information given in the management accounts. The fixed costs (salaries, heating, insurance, depreciation, head office management charges) are likely to be relatively high. Since revenue was below budget, it is likely that the branch contribution was less than expected, hence pulling down overall profit. The branch has only been open for two years, and building up a customer base may be more difficult than anticipated (see also below). It is competing against a variety of other leisure activities for its custom. The lack of track record may also make setting realistic budgets difficult. The policy of restricted opening hours for the general public may be holding back the growth of the branch. Revenue has increased by 1.1% against budget for subscribing members; however, it is down 12.8% for the general public. Consideration should be given to extending opening hours to the general public. The working capital position appears poor. The current ratio is only 0.14 compared to an expected 1.0. This is substantially explained by the large overdraft. If the branch pays full overdraft interest on this balance, a substantial amount of other costs can be explained. Debt collection is a potential problem with $36k outstanding on room hire for social events. Further allowances may be necessary for bad debts. Non current assets were nearly $400k below budget. This could indicate a lack of anticipated investments on fixtures, fittings or major sport equipment. If the branch lacks up to date facilities or a pleasant ambience, this could affect its sales volume. Weakness in current performance indicators (ROI and RI) In the present environment both ROI and RI are essentially giving identical information. The performance of the branch is below target on both indicators. Indeed, had the branch achieved target performance, it would have just attained the minimum required ROI and a break-even RI. That indicates that the branch was probably not expected to perform well, since the minimum targets were set. The branch may pay no overdraft interest since the bank account is pooled centrally. If this is the case, it is in the branch interest to draw funds from its bank account to reduce capital employed and hence increase ROI and RI. The branch is in its formative years. The bulk of capital investment (e.g. premises, swimming pool, gym equipment, etc) was made two years ago. To achieve target ROI and RI will be especially difficult in the early years. Once trade

picks up to a sustainable level and the carrying value of fixed assets is reduced by depreciation charges, then the target figures for ROI and a positive RI can be achieved.

Performance Indicator Monthly revenue by category of business (e.g. swimming, social functions, step aerobics class, etc). Subscription revenue by class of business.

Usefulness

To ascertain branch profile of demand to assist in investment decisions (e.g. new weightlifting equipment). To indicate where facilities may be opened up to the general public if being underutilised by private members. Monthly detailed analysis by category of To indicate areas of over/underspend. cost. Detailed margin analysis of To indicate branches not performing to Net profit margin per branch requisite profit margins the target figures Contribution per activity. could be altered per branch. To indicate activities contributing most significantly to company profits. Alternative computations for ROI and RI. The comparability of branch performance Gross book value of assets and could be enhanced by removing distorting adjustments factors from RI and ROI computation. to asset values for inflation could be used in computation. Analysis of branch cash operating cycle, To manage working capital more current ratio and debtor collection period effectively. Debtor collection period (function sales and subscriptions). should be kept to a minimum for this business. Levels of cancelled bookings for functions,To assist in the formulation of a policy on use of the sports hall, etc. refunds of deposits or demands for payment. Level of complaints/praise received. To establish the level of customer goodwill. Number of accidents or safety incidents. To ascertain the level of safety in the supervision of high risk activities (e.g. lifeguard rescues in the swimming pool). Total capital expenditure on items under To establish that the level of discretionary $2,500. capital expenditure is kept to acceptable limits.
Question 31 BUSINESS SOLUTIONS Scenario (i) South has spare capacity- TP should be marginal cost/Variable cost If North uses the external consultant, the daily contribution to the company is $1,200 $500 = $700. If North uses a consultant from South the daily contribution to the company is $1,200 $100 = $1,100. Therefore the cross charge rate should be set on a level where both North and South will perceive that they will benefit above $100 and below $500 say $300. Scenario (ii)

If North uses the external consultant, the total contribution for one days consultancy in both North and South divisions would be Income VC North 1,200 500 South 400 100 1,600 600 = $1,000

If the South consultant goes to North, then the total contribution would be: $1200 $100 = $1,100 Therefore it is best if North employs the South consultant by setting the cross charge above $400 and below $500, say $450, both parties will benefit and agree to the transaction. Scenario (iii) If the North uses the South Consultant, the total contribution will be: $1200 $100 = $1,100 If North employs the external consultant, the total contribution will be: Income VC North 1,200 500 South 700 100 1,900 600 =$1,300 The lost contribution of the work in South ($600) exceeds the incremental cost ($400) of the external consultant undertaking the work. The company therefore needs to set a cross charge that discourages a consultant going North i.e. above $500 but below $700 Assumptions the objective of the company is to maximise contribution in the short run (not long run considerations) the long term business consequences of rejecting work in the South (Scenario ii) can be ignored the divisional managers behaviour and responses determined only by short term sectional (divisional) financial performance measurement. access to all the decision making data that the separate divisions use. (b) Reasons for re-organization The need to have local knowledge applied specifically to local decisions A divisional company offers the opportunity to make decentralized speedy decisions especially with a rapidly changing environment It permits senior managers to concentrate on global strategic issues detailed operational activities are dealt with separately by those most suitable It permits junior managers to experience broader decision making and can be used as part of their development programme Local semi-autonomous decision making is likely to be a motivating factor for managers (less central control) A divisional structure may reduce the complexity and cost of the communication systems within an unitary hierarchical structure Suggested problems

The senior management may have difficulty in letting go permitting decision to be made locally Senior management may become involved in resolving disputes between the divisions The divisions might eventually compete against each other to the detriment of the entire company Some divisional decisions may not be in the best interests of the entire company (problems of local optimality v global optimality) ensuring goal congruence The potential waste from the duplication of functions Question 32 MANUCO LTD The general rule of transfer pricing to assist in profit maximizing decisions is to set transfer price equal to marginal cost plus net opportunity cost to the group. If we apply this rule to the three situations given we have: Since Helpco Ltd has an external market which is the opportunity foregone, the relevant transfer price would be the external selling price of $15 per kg. This will be adjusted to allow for the $1.50 per kg avoided on internal transfers due to packing costs not required: The transfer price should be $15 $ 1.50 = $13.50 per kg. (ii) Helpco has no external market for 3000 Kg In this situation Helpco Ltd has no alternative opportunity for 3,000kg of its production of special ingredient Z. It should, therefore, offer to transfer this quantity at marginal cost. This is variable cost less packing costs avoided = $9 $1.50 = $7.50 per kg. (Note: total cost = $15 80% = $12 Variable cost = $12 75%= $9. The remaining amount of special ingredient Z should be offered to Manuco Ltd at the adjusted selling price of $13.50 per kg as in (i) above.

(iii) Helpco Ltd has an alternative use for some of its production capacity which will yield a contribution equivalent to $3 per kg of special ingredient Z ($6,000/2,000kg). The balance of its spare capacity (1,000kg) has no opportunity cost and should still be offered at marginal cost. Helpco Ltd should offer to transfer: 2,000kg at $7.50 + $3 = $10.50 per kg; 1,000kg at $7.50 per kg; and the balance of requirements at $13.50 per kg.

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